JULY 2015 ISSUE 190 CONTENTS CARBON TAX Timelines for introduction Cross-border service arrangements

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1 JULY 2015 ISSUE 190 CONTENTS CARBON TAX INTERNATIONAL TAX Timelines for introduction Cross-border service arrangements CAPITAL GAINS TAX Deferral of CGT REPORTABLE ARRANGEMENTS SARS new list COMPANIES Share issue pitfalls VALUE-ADDED TAX Supplies to non-residents DAVIS TAX COMMITTEE BEPS and the transfer pricing of intangibles DEDUCTIONS Subordinated debt and interest thereon SARS NEWS Interpretation notes, media releases, rulings and other documents CARBON TAX Timelines for introduction Introduction The South African government announced that it will publish draft carbon tax legislation in 2015 for public consultation with a view to it becoming law in The Minister of Finance made the announcement during his annual budget speech on 25 February

2 In the limited time until the legislation is tabled and enacted businesses will have the opportunity to come to terms with, and devise a strategy for the impact that a carbon tax may have on their operations. South African companies of all types and sizes and across all industry sectors will need to act decisively to manage the broad commercial implications of the carbon tax. Direct application of the tax will be on a defined set of industry sectors (see discussion below). However, while many businesses will not face direct carbon tax liabilities, they will need to factor in the effect of the carbon tax that will be embedded in their supply chain to enable them to manage changes to their cost base. For example, Eskom will be passing its carbon tax through to the consumer in the form of an increased cost of electricity. Preliminary comments Basic facts: the carbon tax s key design features The carbon tax will be imposed at a statutory rate of R120 per tonne of CO2e (carbon dioxide equivalent), rising 10% a year (R132 in year two; R in year three; etc). The tax relief measures (discussed further below) mean that the effective carbon tax rate will range from R12 to R48 per tonne of CO2e; significantly lower than the statutory carbon tax rate. The carbon tax will cover all direct greenhouse gas emissions from sources that are owned or controlled by the relevant entity. These emissions relate to energy use (fuel combustion and gasification) and non-energy industrial processes. For all stationary sources of emissions the carbon tax will be calculated on the fossil fuel inputs using approved emissions factors or an approved transparent and verified monitoring procedure. For all non-stationary greenhouse emissions (for example, liquid / transport fuels), the carbon tax will be incorporated into the current fuel tax regime. 2

3 Administration of the carbon tax The carbon tax will be included in the Customs and Excise Act. Entities that engage in activities that emit greenhouse gases will be liable for the carbon tax and will need to submit their tax returns based on their own assessment of their emissions. On 2 April 2015 the Department of Environmental Affairs published the mandatory reporting requirements of emissions in South Africa for economic sectors through the National Atmospheric Emissions Inventory System which will begin in January The National Atmospheric Emissions Inventory System / Department of Environmental Affairs will assist with the verification of the self-reported greenhouse gas emissions for the purpose of calculating the carbon tax. Step 1: Determine whether your business is directly liable for the carbon tax The carbon tax will be applied to industry on a sectoral basis. Business operating in these covered sectors will be directly subject to the carbon tax which will be calculated on the fossil fuel inputs that result in Scope 1 greenhouse gas emissions. The meaning of the information columns to the right of the column headed Sector is explained below. Sector Basic Tax Free Threshold Process Trade exposure emission allowance allowance Total Electricity 60% % 10% Petroleum (coal / gas to liquid) 60% 10% - 70% 10% Petroleum - oil refinery 60% 10% - 70% 10% Iron & steel 60% 10% 10% 80% 5% Cement 60% 10% 10% 80% 5% Glass & ceramics 60% 10% 10% 80% 5% Chemicals 60% 10% 10% 80% 5% Pulp & paper 60% 10% - 70% 10% Sugar 60% 10% - 70% 10% Offset percentage 3

4 Agriculture, Forestry 60% - 40% 100% 10% and Land Use Waste 60% - 40% 100% - Fugitive emissions: 60% 10% 10% 80% 5% Coal mining Other 60% 10% - 70% 10% Step 2: Determine whether your business s direct carbon tax liability may be reduced or eliminated Businesses operating in the covered sectors may reduce or eliminate their direct carbon tax exposure in the following ways: Direct exposure to the carbon tax Basic tax free threshold The 60% basic tax free threshold may be adjusted upward or downward by 5 percentage points depending on carbon intensity. It will be necessary for companies to perform carbon footprint exercises so that they can determine the carbon intensity of their operations. Trade exposure allowance The carbon tax design includes a trade exposure allowance of 10% for qualifying entities. This concession will be structured as a graduated relief. Firms will have the option to use exports only or exports plus imports as a percentage of outputs or sales to determine their trade exposure. This measure is limited as it examines the business's emissions intensity. Further analysis might be needed to ensure an optimal provision for international competitiveness relief for trade exposed emissions intensive sectors. Process emission allowance Tax relief for emissions-intensive businesses which have structural or technical difficulties in reducing their emissions intensity will be included in the design of the carbon tax. 4

5 Carbon offsets Carbon tax liable entities will be able to reduce their carbon tax liabilities by purchasing carbon credits from non-carbon tax liable entities. Carbon tax liable entities will have to compare the benefits of purchasing the carbon credits or simply paying the carbon tax. If the carbon credit purchase route is selected then a certain amount of due diligence will be required to ensure that the purchased carbon credits meet the eligibility requirements. The JSE recently conducted a demonstration trade in which it showed how carbon credits housed in carbon registries outside of South Africa could be traded through the JSE s trading platform. Indirect exposure to the carbon tax Step 3: Act on opportunities to pass through costs: long term agreements In certain long term agreements, prices may be locked-in for the period of the agreement and will likely continue to apply well after the introduction of the carbon tax. This has potentially disadvantageous results, e.g., a manufacturer of goods subject to carbon taxation (from say 1 July 2016) on the emissions associated with the manufacturing process might be constrained from passingon this cost increase to clients as a result of a long-term sales agreement which locks-in the price of the goods. Those who will be adversely impacted may wish to seek legal advice as to whether their current long term contracts do or do not provide for variation to prices on account of the carbon tax. Future long term contracts should have clauses that properly deal with adjustments to price on account of the carbon tax. Step 4: Consider the impact of the carbon tax on acquisition strategies Ensuring compliance with the carbon tax should become part of standard due diligence practices when acquiring carbon tax liable corporate entities. In this regard, a full suite of warranties ensuring that the target entity is compliant with its carbon tax obligations, similar to tax warranties, should be considered. 5

6 Companies not directly subject to the carbon tax Even if a business is not directly subject to the new carbon tax, it may face an increase in input costs. For example, electricity prices or other inputs may increase in price due to a supplier being subject to the carbon tax. Businesses may respond to this challenge in several ways: retrofit their operations to reduce their energy consumption thereby qualifying for the energy efficiency savings tax allowance in section 12L of the Income Tax Act 58 of 1962, or adjust their prices to deal with the impact of the carbon tax. Section 12L which contains a deduction of 45c per kilowatt hour on proven energy efficiency savings will be amended by increasing the deduction to 95c per kilowatt hour. Concluding remarks Every business will need to have a strategy to factor in the costs (direct or indirect) of the carbon tax. In addition, attention should be given to managing financial impacts such as a changing cost base, acting on opportunities to pass through costs and identifying and responding to tax implications. ENSafrica ITA: Section 12L CAPITAL GAINS TAX Deferral of CGT Put simply, capital gains tax (CGT) is levied on the capital gain arising on the disposal of an asset, that is, on the difference between the base cost of the asset and the proceeds accruing on disposal. In terms of paragraph 35(4) of the Eighth Schedule to the Income Tax Act 58 of 1962 (the Act) when a person disposes of an asset during a current tax year and 6

7 that person becomes entitled to any amount which is payable in future tax years, that amount is deemed to have accrued to that person during the current tax year. So, if the price of an asset is paid, say, in three equal instalments over three tax years, the person disposing of the asset must account for CGT on the full price in the first tax year, that is, the year of the disposal. That provision is perhaps inequitable as the cash flow does not follow the incidence of tax. Fortunately, there are some principles that mitigate the harsh effects of the rule. First, it is trite that the rule will only apply to the extent that the person becomes unconditionally entitled to some or all of the proceeds; to the extent that the entitlement to future proceeds is conditional upon the happening of an event, the taxpayer would only need to account for CGT on the future proceeds if and when the event occurs. Second, in terms of section 24M(1) of the Act, to the extent that the proceeds on disposal of an asset will only be quantifiable at a future date, the taxpayer need only account for CGT when the amount becomes quantifiable. For example, if a person sells shares in a company on the basis that a part of the price will be determined with reference to the net profits of the company in a future tax year, then the person would only need to account for CGT in the future tax year when the amount becomes quantifiable. Third, section 24N of the Act provides that, if a person disposes of equity shares in a company for a quantified or quantifiable amount that only becomes due and payable in a future tax year, then the person need only account for CGT in a future year as and when it becomes due and payable, provided certain requirements are met. Notably, the provision only applies if the amount payable is determined with reference to the future profits of the company. 7

8 In the case of Gani v Hassim; In re: East Coast Access (Pty) Limited v Gani [2015] JOL (KZD), Mr Gani sold his shares in a company to Mr Hassim. The price of the shares was R5 million in aggregate. The evidence indicated that the parties agreed that Mr Hassim would not pay the price in a lump sum in year one, but in equal monthly instalments over three years with a bullet payment of R2 million at the end of year three. However, Mr Gani's accountant referred him to the provisions of paragraph 35(4) of the Eighth Schedule to the Act. The accountant advised Mr Gani that he would have to pay CGT in year one, despite the fact that he would only receive the price over a period of three years. The accountant, however, also informed Mr Gani that the principle would not apply if the receipt of the price was made subject to a condition, in which event he would only have to pay the CGT when the condition was fulfilled. For that reason the parties inserted a condition into the agreement between them to the effect that the price would only be paid if the company generated certain levels of profit. A subsequent dispute arose between the parties. Mr Hassim alleged that, because the agreed profit levels were not attained, he was not obliged to pay Mr Gani the bullet payment of R2 million. The court found that [t]he evidence and the probabilities indicate overwhelmingly that the purpose of the condition regarding the profit target was to delay the payment by Mr Gani of capital gains tax. This was the evidence of Mr Gani and [the accountant], and also Mr Hassim. I do not accept the contention that the purpose of the condition was to ensure that Mr Hassim would be able to pay the entire purchase price out of the profit of the company. Its only purpose was to delay the payment of capital gains tax by bringing the agreement within the ambit of paragraph 13 of Schedule 8 [which relates to the timing of a disposal] or section 24N of the Act. 8

9 The South African Revenue Service (SARS) may be interested in the finding of the court for the reasons that follow. First, it is trite that if parties come to an agreement and do not really intend the agreement to have, as between them, the legal effect which its terms convey to the outside world, then the agreement is simulated, and a court will not give effect to the agreement (Commissioner of Customs and Excise v Randles, Brothers & Hudson Ltd (1941) AD 369). As Lewis JA said in the case of Commissioner for the South African Revenue Service v NWK Limited [2011] 73 SATC 55, [i]f the purpose of the transaction is only to achieve an object that allows the evasion of tax then it will be regarded as simulated. In the Gani case the court found on the evidence that the sole purpose of the provision in the agreement was to make the payment of the bullet payment contingent on the company achieving the relevant profit levels. If that provision was not meant to be binding between the parties (an issue which neither the parties nor the court canvassed) then the provision was simulated and should be disregarded for the purpose of determining the incidence of tax. If it is disregarded, then Mr Gani should have paid CGT on the full price at the time of the sale. Second, in terms of section 80B(1) of the Act, in the case where a taxpayer has entered into an impermissible avoidance arrangement, SARS has the power, among other things, to determine the tax consequences by disregarding any steps in, or parts of the arrangement. In terms of section 80A of the Act, an arrangement that results in a tax benefit is an impermissible avoidance arrangement if the sole or main purpose of the arrangement was to obtain a tax benefit and, among other things, it lacks commercial substance. Section 80C(1) of the Act states that an avoidance arrangement lacks commercial 9

10 substance if, among other things, it results in a tax benefit for a party but does not have a significant effect on either the business risks or net cash flows of the party. In terms of the definition of tax benefit in section 1, the postponement of any liability for tax is a tax benefit. If the finding of the judge in the Gani case as to the evidence is correct then, arguably, the condition in the agreement, pertaining to the profit levels, having been inserted (according to the judge) only for the purpose of postponing the liability for CGT (a tax benefit), may be seen to be an impermissible avoidance arrangement because it had no effect on the net cash flows of Mr Gani. In the Gani case the court held that the profit levels had been attained and that Mr Gani was, accordingly, entitled to the R2 million bullet payment. What the case illustrates is that parties to agreements that have the effect of deferring CGT should exercise great caution. Cliffe Dekker Hofmeyr ITA: Section 1 Definition of Tax Benefit, sections 24M(1), 24N, 80A, 80C(1), Paragraphs 13, 35(4) and Paragraph 8B(1) of the Eighth Schedule COMPANIES Share issue pitfalls Generally there are no tax consequences when a company issues shares. This is the case regardless of whether the shares are issued for cash or in order to settle the purchase consideration that may have arisen pursuant to the acquisition of 10

11 assets by the company. This follows from the provisions of paragraph 11(2)(b) of the Eighth Schedule to the Income Tax Act 58 of 1962 (the Act) to the extent that there is no disposal of an asset by a company in respect of the issue of a share in the company. Unfortunately there are some exceptions to the general rules. The first issue that one should consider is whether the market value of the shares is commensurate with the market value of the assets that are acquired by the company. Section 24BA of the Act applies when the consideration would have been different had the asset been acquired in exchange for the issue of the shares in terms of a transaction between independent persons dealing at arm s length. In particular, if the market value of the assets so acquired exceeds the market value of the shares after the issue by the company, the difference is not only deemed to be a capital gain in the hands of the company, but the disposer must also reduce the base cost of the shares in the hands of the disposer. Conversely, should the market value of the shares exceed the market value of the assets, the difference is deemed to be a dividend that has been distributed by the company in specie and is deemed to have been paid by the company on the date of the issue of the shares. It is thus quite important for both the purchaser and the seller to consider the value of the assets and shares in these circumstances. These deeming provisions do not apply in scenarios where the seller and the purchaser form part of the same group of companies. More importantly, however, is that there are also negative tax consequences for parties where a company issues shares and acquires, directly or indirectly, shares in foreign companies as part of the issue of the shares. In particular, paragraph 11(2)(b) provides that there is a disposal of an asset to the extent that the shares issued by a company are in exchange, directly or indirectly, for shares in a foreign company. In other words, should a company in South Africa 11

12 (X) issue shares with a view to settle the purchase consideration by X acquiring shares in a foreign company (B), then X will be subject to capital gains tax on the issue of the shares even though there is no cash involved in the transaction. Unfortunately, this deeming provision is not only limited to a scenario where there is a direct issue of shares in exchange for the acquisition of shares in the foreign company. The adverse tax consequences will also apply where, for example, company B issues shares to a South African resident (A), in circumstances where A, in turn, holds interests in foreign companies. Recently there have been a number of transactions where parties did not fully take into account these deeming provisions, especially to the extent that international interests were acquired, directly or indirectly. The original intention behind these provisions may have been to prohibit a reverse takeover in circumstances where the number of shares that are issued by the South African company may result in a change in control, but the technical interpretation of this section has the unintended result of a number of innocent transactions falling foul of this deeming provision. This is one of the reasons why the Budget proposals recently indicated that the deeming provision may be revisited. The proposals acknowledged that the relevant provisions may have affected legitimate commercial transactions, curtailing the growth in expansion of South African multinationals. In other words, multinationals would not be able to compete in the international market as the norm in international transactions is to at least partly issue shares in order to fund the acquisition of international interests. It was indicated that National Treasury will consider relaxing these provisions even though the original intention to counter untaxed corporate migration out of South Africa - will prevail. The issue will thus need to be solved by carefully worded amendments and specific consideration needs to be given to what extent, if at all, these amendments are retrospective from the date of the announcement. 12

13 In the meantime, corporates must be wary of issuing shares as part of multilayer transactions, especially to the extent that indirect interests may be acquired in foreign companies as part of the issue of shares. Cliffe Dekker Hofmeyr ITA: Section 24BA and paragraph 11(2)(b) of the Eighth Schedule DAVIS TAX COMMITTEE BEPS and the transfer pricing of intangibles The Davis Tax Committee (DTC) recently addressed the issue of base erosion and profit shifting (BEPS) in South Africa. The international importance of transfer pricing was once again emphasised when 4 out of the 15 actions identified in the OECD Action Plan on BEPS related to transfer pricing. The 15 actions are scheduled to be finalised in three phases, and the DTC issued its interim report on the first of these phases, i.e. the September 2014 deliverables. A summary of the DTC s conclusions and recommendations on Action Plan 8: Assure that Transfer Pricing Outcomes are in line with Value Creation / Intangibles are set out below. The OECD has in the past done extensive work on the transfer pricing of intangibles which are in line with Action Plan 8. In Action Plan 8, the OECD recommends that countries develop rules to prevent BEPS by moving intangibles among Multinational Enterprise (MNE) group companies. This will involve: (i) adopting a broad and clearly delineated definition of intangibles; 13

14 (ii) (iii) (iv) ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation; developing transfer pricing rules or special measures for transfers of hardto-value intangibles; and updating the guidance on cost contribution arrangements. The DTC reiterates that transfer pricing is a key focus area for SARS and that the South African Reserve Bank has been approached to assist in determining the magnitude of BEPS relating to transfer pricing. The DTC s interim report lists certain recommendations on transfer pricing in general in South Africa. The DTC recommends that the legislators should ensure that section 31 of the Income Tax Act 58 of 1962 (the Act) itself, and not only SARS Practice Note 7 which is not legally binding, refer to the OECD Transfer Pricing Guidelines. The DTC suggests for this purpose that a legally binding General Ruling as provided for in terms of the Tax Administration Act 28 of 2011 be enacted under section 31 and that the General Ruling should, without departing from the OECD Transfer Pricing Guidelines, include principles reflecting the South African reality. The DTC also recommends that SARS should ensure that the enforcement capacity of its transfer pricing unit is adequate and that there is sufficient training and capacity building in this unit. The BEPS concern in relation to South African-owned intellectual property (IP) is the possibility that MNEs may transfer valuable IP to low tax or tax-free jurisdictions to ensure a flow of royalty income to that jurisdiction. In assessing this concern, the DTC, amongst others, considered the South African exchange control rules which prohibits the export of South African developed IP and requires South African based owners of IP, which make the IP available to foreign related parties, to charge an appropriate royalty for the IP. 14

15 The DTC came to the conclusion that Action Plan 8 may not require major legislative attention in South Africa at this stage. The DTC is of the opinion that the exchange control restrictions mentioned above, the punitive tax consequences in terms of section 23I of the Act for the payments of royalties by South African taxpayers which previously used to own the relevant IP and the concept of beneficial ownership in the royalty article of double taxation agreements, amongst others, readily prevent transfer pricing of intangibles in South Africa. The DTC, however, is of the view that the potential undervaluation of local intangibles in determining profit splits as well as contract R&D arrangements which are highly artificial or lacking in substance are of potential concern for South Africa. The DTC further cautions that care should be taken in developing tax legislation on transferring of intangibles that is too restrictive and that limits the development of IP in South Africa. ENSafrica ITA: Section 23I and section 31 SARS Practice Note 7 OECD Transfer Pricing Guidelines Editorial Comment: Under the chairmanship of Judge Dennis Davis, the committee has been tasked with an enquiry into the role of the tax system in the promotion of inclusive economic growth, employment creation, development and fiscal sustainability. A number of reports have already been issued by the committee and more will follow. While we will be publishing articles on the work and reports of the committee, it must be recognised that not all of its recommendations will be accepted by our Minister of Finance and find their way into our tax legislation. 15

16 DEDUCTIONS Subordinated debt and interest thereon From 1 April 2014, interest incurred on subordinated debt is no longer deductible. Section 8F of the Income Tax Act 58 of 1962 (the Act) is an anti-avoidance provision which deems interest on hybrid debt instruments to be a dividend in specie and effectively disallows the deduction of affected interest. Section 8F applies in respect of amounts incurred on or after 1 April The disallowed interest is regarded as a dividend in specie in the hands of both the debtor and creditor with the result that the dividend receipt should usually be exempt from income tax. Where dividends tax is payable, it must be borne by the debtor (and not the creditor as is the case with dividends other than dividends in specie). If the creditor is a South African tax resident company, the entity is exempt from the dividends tax. In its simplest form, section 8F applies to interest incurred on loans between connected persons where the loans are not repayable within 30 years and are not payable on demand. However, the section also applies to interest incurred on subordinated debt. Paragraph (b) of the definition of hybrid debt instrument includes an arrangement where the obligation to pay an amount in respect of that instrument is conditional upon the market value of the assets of that company not being less than the market value of the liabilities of that company. 16

17 Subordination Agreements are commonly used in group scenarios and typically contain the following clause: The Creditor hereby agrees that, until such time as the assets of the Company fairly valued exceed its liabilities, it shall not be entitled to demand or sue for or accept repayment of the whole of any part of the said amount owing to it by the company and set-off shall not operate in relation to the subordinated claim in respect of any debts owing by it now or in the future; provided that if the auditor of the Company shall report in writing that he has been furnished with evidence which reasonably satisfies him that the amount of the subordinated claim exceeds the amount by which the liabilities of the Company exceed its assets, such excess portion of the subordinated claim as is specified in the said certificate shall be released from the operation of this agreement. In most cases, the natural conclusion would be simply to delete this clause from the Subordination Agreement. However, to delete the above clause does not change the intrinsic legal nature and effect of a Subordination Agreement. The legal effect of a loan subordination is that repayments can only commence once the assets of the debtor, fairly valued, exceed its liabilities, also fairly valued, which places subordinated debt squarely within the parameters of par (b) of the definition of a hybrid debt instrument. Furthermore, in the case of Ex Parte De Villiers and Another NNO: In re Carbon Developments (Pty) Ltd (1993) (1) SA 493, Goldstone JA made the following remarks: Save possibly in exceptional cases, the terms of a subordination agreement will have the following legal effect: the debt continues to exist but its enforceability is made subject to the fulfilment of a condition. Usually the condition is that the debt may be enforced by the creditor only if and when the value of the debtor s assets exceeds his liabilities, excluding the subordinated debt In the event of the insolvency of the debtor, [liquidation] would normally mean that the condition upon which the enforceability of the debt 17

18 depends will have become incapable of fulfilment. The legal result of this would be that the debt dies a natural death. The result would be that the erstwhile creditor would have no claim which could be proved in insolvency The debt would not normally survive [liquidation]. It is quite clear that the legal nature of a Subordination Agreement cannot be changed by amending the wording contained therein. The substance and true legal intention of the agreement remains even though the words giving effect thereto may be altered. There is accordingly a significant risk to taxpayers who have entered into Subordination Agreements that section 8F will apply. A further hindrance is that by their nature, subordinated loans cannot be repayable on demand, which could otherwise potentially place them beyond the ambit of section 8F. It s important to bear in mind, however, that section 8F will only apply to interest-bearing subordinated debt, so taxpayers with interest-free subordinated debt may rest assured that at this stage they do not fall within the section 8F net. Grant Thornton ITA: Section 8F INTERNATIONAL TAX Cross-border service arrangements Part 1: Recent Developments With the increasing focus on cross-border payments in the context of profit shifting, management services in general, have recently become a main focus area of the South African Revenue Service (SARS) due to the substantial amounts of money flowing from South Africa on an annual basis as payments for management and related fees. In this regard, the Davis Tax Committee, in analysing the impact of base erosion and profit shifting (BEPS) on South 18

19 Africa, reviewed data obtained from the South African Reserve Bank (SARB) which shows that for the calendar years 2008 to 2011 nearly 50% of all nongoods payments flowing out of South Africa related to legal, accounting and management consulting fees. This article sets out a brief summary of the various relevant issues which need to be considered in the context of management services for many multinationals. This article deals with the recent developments in the context of cross border service arrangements, including the requirement for non-residents to register for income tax in South Africa, as well as the withholding tax on service fees which comes into effect on 1 January Requirements for a non-resident service provider to register and submit income tax returns In terms of the notice issued by the Commissioner in relation to the 2014 year of assessment (2014 Notice), non-resident companies are required to submit an income tax return if, inter alia, they derive service income from a source in South Africa. It is important to understand that the ultimate objective of the registration requirement is for SARS to be able to identify non-resident service providers that earn service income from a South African source that is either not protected from South African tax as a result of a double tax agreement or where such income may be attributed to a permanent establishment (PE) of such non-resident service provider in South Africa. Although the Income Tax Act 58 of 1962 (the Act) contains a definition of source in respect of certain forms of income, it does not specifically address the source of service income and therefore it is necessary to consider the common law source principles as distilled from case law. 19

20 South African case law indicates that the source (originating cause) of income received for services rendered are the services themselves. The source of such income is located at the place where these services are provided. In the context of services, the activities test is generally applied to determine the source of the income, i.e. the place where the services are rendered prima facie constitutes the source of the income. Should a non-resident group entity render services to the local entity from outside of South Africa, the service income derived therefrom should not be regarded as being sourced in South Africa and accordingly there should be no obligation for such non-resident entity to register and submit an income tax return. However, the position may be different if, for example, these services are rendered in South Africa or partly in South Africa. Should this be the case, it may then give rise to South African sourced income, triggering an obligation for such non-resident group entity to register for income tax in South Africa. Withholding tax on service fees The withholding tax on service fees comes into effect on 1 January 2016 and will be levied at a rate of 15% in respect of the amount of any service fee that is paid by any person to or for the benefit of any foreign person to the extent that the amount is regarded as having been received or accrued to that foreign person from a source within South Africa. Should a local company receive, inter alia, management services from a nonresident group entity, the withholding tax on service fees may apply to payments to the non-resident group entity for such management services to the extent that the amount is regarded as having been received or accrued to the non-resident entity from a source within South Africa. This would be the case where, for example, the non-resident group entity sends individuals to South Africa to render management or consulting services to the local entity. This would result in the local entity having an obligation to withhold the withholding 20

21 tax and to pay such amounts over to SARS. In addition it will have a compliance obligation in terms of rendering a return to SARS in respect thereof. It is noted that failure to withhold or pay these taxes to SARS could result in the person that is required to withhold the tax (i.e. the local entity receiving the management services) being personally liable for the tax. In addition, penalties may be levied in certain instances for the failure to withhold or correctly withhold. The position may be different in a scenario, where the non-resident entity provides the management services from outside of South Africa. In this case, the source of such income should not be regarded as being in South Africa and accordingly the withholding tax provisions should therefore not apply. As such, no withholding obligations would be placed on the local entity receiving the management services. At this stage it is unclear how the withholding tax on service fees would apply to service income from multiple sources (for example in a scenario where management services may be partly rendered from South Africa and partly from outside of South Africa). Furthermore, the definition of service fees currently refers to amounts received or accrued in respect of technical services, managerial services and consultancy services, but no guidance has been provided by SARS on what type of services would fall under these subcategories, e.g. what would constitute services of a technical nature? It is noted in the 2015 Budget Speech read by the Minister of Finance on 25 February 2015 that it is proposed that the provisions dealing with the withholding tax on services be reviewed to clarify definitions and remove any anomalies. Given the above statements in the Budget Speech and also the fact that no specific guidance or declarations have been released by SARS on the withholding tax on service fees to date, we expect to see amendments to the these provisions which are already contained in sections 51A to 51H of the Act. 21

22 Reportable arrangements A further issue to consider, is whether service arrangements constitute a reportable arrangement in terms of the Tax Administration Act 28 of 2011 (the TAA). The TAA provides that an arrangement may constitute a reportable arrangement in two scenarios, one of which is if the arrangement is listed in section 35(2). Section 35(2) provides that an arrangement is a reportable arrangement if the Commissioner has listed the arrangement in a public notice. It is noted that in the context of service fees, SARS issued a Draft Notice on Reportable Arrangements (Draft Notice), in The Draft Notice sets out certain arrangements which SARS identified to have certain characteristics that may lead to an undue tax benefit and therefore will be regarded as a reportable arrangement, triggering a duty to disclose such arrangement to SARS. Most relevantly, the following was set out in the Draft Notice to be a reportable arrangement: any arrangement in terms of which fees that are payable or may become payable, on or after the date of publication of this notice, by a person that is a resident to a person that is not a resident with regard to services rendered to that resident in the Republic, exceed or are reasonably expected to exceed R5 million. Further to the Draft Notice, a public notice (the Notice) was issued in the Government Gazette on 16 March 2015 in terms of which the Commissioner for 22

23 the South African Revenue Service (SARS) lists various arrangements as reportable arrangements in terms of section 35(2) of the TAA. We note that the Notice no longer lists arrangements in terms of which fees are payable by a person that is resident for services rendered to a non-resident which exceeds R5 million as set out above. Accordingly, at this stage the abovementioned service arrangements should not be regarded as a reportable arrangement in terms of section 35(2) of the TAA. Conclusion It is important that taxpayers be aware of the above mentioned considerations in respect of cross-border service arrangements. We note that the requirements for non-residents to register for income tax in South Africa as well as the applicability of the withholding tax on service fees is only relevant to the extent that the service income, derived by such non-resident, is regarded as being from a South African source. Should the non-resident service provider derive service income which is not from a source in South Africa, then the requirement to register for income tax in South Africa, as well as any withholding tax on service fees, should not be applicable. We recommend that taxpayers who pay, inter alia, service fees to non-resident service providers, perform a detailed analysis regarding the source of such service income in order to, inter alia, establish their obligations in respect of the withholding tax on service fees. Similarly the non-resident service provider should analyse the source of any service income derived in respect of the provision of services to a South African taxpayer in order to consider its obligations to register for income tax in South Africa as set out above. ENSafrica ITA: Sections 51A to 51H TAA: Section 35(2) 23

24 SARS Notice 212 in Government Gazette No of 16 March 2015 SARS Draft Notices 2014 and 2015 on Reportable Arrangements REPORTABLE ARRANGEMENTS SARS new list SARS list of reportable arrangements, as envisaged by section 35 of the Tax Administration Act 28 of 2011 (the TAA), has been widened extensively. The arrangements, deemed reportable, were published on 16 March 2015 in a public notice (the Notice) in the Government Gazette. Reportable arrangements must be reported to SARS within 45 business days after becoming a participant in a reportable arrangement or 45 business days after the date on which an arrangement qualifies as a reportable arrangement. Every participant has the duty to disclose the prescribed information regarding the arrangement to SARS unless the participant obtains a written statement from another participant that the other participant has disclosed the arrangement. Failure to disclose, results in severe penalties. Participants other than the promoter are subject to a penalty of R per month whilst the promoter is subject to R per month (up to a maximum of 12 months). If the participant s anticipated tax benefit exceeds R5 million the penalty is doubled and if it exceeds R10 million the penalty is tripled. SARS may remit up to R of the penalty in the case of a first incidence or where the noncompliance endures for less than 5 business days. The remission will only be done if SARS is satisfied that reasonable grounds exist for the failure to report and that the issue has been resolved. In all other instances, the penalty may only be remitted in exceptional circumstances. Where SARS casts the list of reportable arrangements too widely, taxpayers may inadvertently be subject to the draconian penalty regime - even on transactions believed to be normal business. This places an enormous 24

25 responsibility on the taxpayer and tax advisors. The notice excludes arrangements where the tax benefit to all participants in aggregate does not exceed R5 million, from being reportable. Taxpayers can no longer rely on Government Notice 384, which excluded arrangements where the tax benefit was not the main or one of the main benefits of an arrangement. The new list has been changed considerably from the list gazetted on 28 December 2012, which contained only two categories, namely an arrangement that would have qualified as: A hybrid equity instrument (section 8E of the Income Tax Act 58 of 1962 (the ITA)) if the prescribed period had been 10 years; and A hybrid debt instrument (section 8F of the ITA) if the prescribed period had been 10 years (other than listed debt instruments). These two categories are contained verbatim in the new list, although section 8F was substituted (effective 1 April 2014) and no longer refers to a 3 year period. It is arguable that this category only applies to instruments that were issued pre- 1 April 2014 in respect of hybrid debt instruments. The Notice includes the following remaining categories of arrangements in terms of which: A company buys back shares, from date of publication of the Notice, from one or more shareholders for an aggregate amount of at least R10 million, if the company issued or is required to issue any shares within 12 months of entering into the arrangement or of the date of any buy-back in terms of that arrangement. A resident makes contributions or payments, from date of publication of the Notice, to a non-resident trust and acquires a beneficial interest in that trust in circumstances where the contributions, payments or the value of the interest exceeds or is reasonably expected to exceed R10 million. Contributions, payments or a beneficial interest acquired in a foreign 25

26 collective investment scheme in securities or participation bonds, or a foreign investment entity as defined are excluded from the ambit of this category. A person(s) acquires the controlling interest in a company (by the acquisition of shares or voting rights from date of publication of the Notice) that has carried forward or expects to carry forward a balance of assessed loss exceeding R50 million from the previous year of assessment to the year of assessment in which the controlling interest is acquired. It also includes the acquisition of the controlling interests in a company that expects to realise an assessed loss exceeding R50 million in the year of assessment during which the controlling interest is acquired. It also includes an indirect acquisition of a controlling interest in a company with this quantum of assessed losses. An amount that exceeds or is likely to exceed R5 million is or becomes payable by a resident to an insurer that qualifies as an insurer in terms of any foreign law, if: An aggregate amount that exceeds or is reasonably expected to exceed R5 million has been paid or becomes payable by the resident to the foreign insurer (irrespective of when such amounts became or become payable); and An amount payable on or after the date of publication of this notice, in cash or otherwise, to a beneficiary in terms of that arrangement is to be determined mainly by reference to the value of particular assets or categories of assets held by or on behalf of the foreign insurer or by another person for purposes of the arrangement. Section 35(1) of the TAA includes other types of arrangements that are reportable in addition to those listed above and section 36 contains a number of exclusions. We list the other types of arrangements included in section 35(1) 26

27 below and the excluded arrangements in terms of section 36 immediately thereafter. Section 35(1) includes arrangements where a person is a participant in the arrangement and the arrangement: Contains provisions in terms of which the calculation of interest (as defined in section 24J of the ITA), finance cost, fees or any other charges is wholly or partly dependent of the assumptions relating to the tax treatment of that arrangement (other than the reason of any change in the provisions of the ITA). Has any of the characteristics contemplated in section 80C(2)(b) of the ITA, or substantially similar characteristics, i.e. round trip financing (per section 80D), an accommodating or tax indifferent party (per section 80E) or cancelling or offsetting elements. Gives rise to an amount that is or will be disclosed by any participant in any year of assessment or over the term of the arrangement as o a deduction for purposes of the ITA but not as an expense for purposes of financial reporting standards ; or o revenue for purposes of financial reporting standards but not as gross income for purposes of the ITA. Does not result in a reasonable expectation of a pre-tax profit for any participant. Results in a reasonable expectation of a pre-tax profit for any participant that is less than the value of that tax benefit to that participant if both are discounted to a present value at the end of the first year of the assessment when that tax benefit is or will be derived or is assumed to be derived, using consistent assumptions and a reasonable discount rate for that participant. Section 36 of the TAA excludes the following arrangements: 27

28 A debt in terms of which the borrower receives or will receive: An amount of cash and agrees to repay at least the same amount of cash to the lender at a determinable future date. A fungible asset and agrees to return an asset of the same kind and of the same or equivalent quantity and quality to the lender at a determinable future date. A lease. A transaction undertaken through an exchange, regulated in terms of the Securities Services Act, A transaction in participatory interests in a scheme, regulated in terms of the Collective Investment Schemes Control Act, The section 36 exclusions only apply to an arrangement that: Is undertaken on a stand-alone basis and is not directly or indirectly connected to any other arrangement (whether entered into between the same or different parties). Would have qualified as having been undertaken on a stand-alone basis as required by paragraph (a), were it not for a connected arrangement that is entered into for the sole purpose of providing security and if no tax benefit is obtained or enhanced by virtue of the security arrangement. The section 36 exclusions do not apply to an arrangement entered into: With the main purpose or one of its main purposes being to obtain or enhance a tax benefit. In a specific manner or form that enhances or will enhance a tax benefit. With the extended list of the reportable arrangements it is now even more critical that taxpayers familiarise themselves of these changes to avoid the fiscus commanding the severe penalties that SARS could impose. 28

29 BDO ITA: Sections 8E, 8F, 24J, 80C(2), 80D and 80E TAA: Sections 35(1) and 36 Government Notice 212 in Government Gazette No of 16 March 2015 Government Notice 384 in Government Gazette of 1 April 2008 Government Notice 1108 in Government Gazette of 28 December 2012 Editorial Comment: Please refer to Government Notice 212 issued on 16 March 2015) VALUE-ADDED TAX Supplies to non-residents On 30 March 2015 the tax court delivered judgment in the matter of ABD CC v Commissioner for the South African Revenue Service [2015] TC VAT 969 CTN. The matter concerned the value-added tax (VAT) treatment of the supply of goods and services to non-residents in circumstances where such goods and services are physically supplied to and consumed by a person within South Africa. The vendor had certain agreements in place with foreign tour operators in terms of which the vendor would arrange tours in South Africa. The foreign tour operators, in turn, sold tour packages to their customers, who were foreign tourists wishing to visit South Africa. The tour packages would ordinarily include accommodation, meals at restaurants, guided tours and excursions. The vendor entered into agreements with local service providers (hotels, restaurants, etc.) in order to procure these services for the foreign tour operators and ultimately the foreign tour operators customers, being the tourists. 29

30 The local service providers invoiced the vendor for their services, and the vendor paid them. The vendor, in turn, invoiced the foreign tour operators for its services, and the foreign tour operators paid the vendor. The vendor accounted for VAT at the zero rate in respect of the services that it provided to the foreign tour operators on the basis that they were non-residents, and that section 11(2)(l) of the Value-Added Tax Act 89 of 1991 (the VAT Act) applied. Section 11(2)(l) of the VAT Act provides that: (2) Where, but for this section, a supply of services would be charged with tax at the rate referred to in section 7(1), such supply of services shall be charged with tax at the rate of zero per cent where (l) the services are supplied to a person who is not a resident of the Republic, not being services which are supplied directly (iii) to the said person or any other person, other than in circumstances contemplated in subparagraph (ii) (bb), if the said person or such other person is in the Republic at the time the services are rendered The South African Revenue Service (SARS) did not agree that the supply of the services could be zero-rated in terms of section 11(2)(l) of the VAT Act because, in its view, the vendor rendered services to the tourists while they were in South Africa, and the exclusion contained in section 11(2)(l)(iii) of the VAT Act applied. SARS assessed the vendor accordingly. The vendor objected to the assessment, but SARS disallowed the objection against the imposition of VAT and interest. The vendor then appealed to the Tax Court. After analysing the relevant documentary and oral evidence, the court seems to suggest that the correct construction to be placed on the contractual relationships between the parties was that the local service providers supplied a service to the vendor, which enabled the vendor to supply a service 30